AIFs see more institutional, Family Office investment after Budget clarifies treatment of capital gains

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With the Union Budget providing clarity on taxation of Category I and II Alternative Investment Funds (AIFs), experts see more institutional capital coming into Indian equities, with Family Office flows too likely to see a rise.

In order to clear the tax uncertainty for AIFs, the Union Budget had clarified that income generated by Category I and II AIFs will be treated as capital gains. Till now, there was no specific provision on how such income would be treated — either as capital gains or business income.

In the Budget 2025, government had expanded the definition of capital asset to include gains made by AIFs under the Income Tax Act, a move that is expected to benefit Indian AIFs.

Siddarth Pai, founding partner at 3one4 Capital said the classification of securities held by an Indian AIF as a 'capital asset' will ensure all gains from their sale will be taxed as capital gains, and not 'business income'.

“This move will lead to lot of institutional capital coming to India, as it will provide certainty that all the gains will be classified as capital gains and not business income. It will in turn give a major boost to the attractiveness of Indian AIFs and will help increase capital formation in India and for Indian entrepreneurs,” Pai said.

For capital gains, there is a concessional tax rate - if it is long-term gain, the tax is 12.5% - and if it is business income, it is taxed at the maximum marginal rate applicable to the entity, said SR Patnaik, Partner (Head - Taxation), Cyril Amarchand Mangaldas.

Patnaik added that in the case of business income for newly incorporated companies, the tax rate could be 22.5% if the entity wishes to be covered under the new tax regime, while for others it could be 30%.

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Patnaik added that while this could boost fund raising, it is unlikely to trigger a sudden surge in FDI. "It simply adds another investment avenue for the potential non-resident investors as most FPIs already understand the Indian market," he said.

However, this development may be more relevant for Family Offices of large HNIs and billionaires, including those from the Middle East, as it clarifies earlier complexities, Patnaik added.

The move will benefit debt investments more, said Tushar Sachade, Partner, Price Waterhouse & Co LLP.

“There is a greater risk of debt investments by AIFs being recharacterized as business income. In which case there is a risk of the said income being taxed in the hands of the fund at maximum marginal rate of 39%. However, with the recent amendment, debt-related capital gains and interest income is likely be taxed on pass through basis in the hands of the investors. Therefore, the corporate investors under the new tax regime would be taxed at 25%. Further, the non-resident investors would be able to claim the treaty benefit and will be able to take advantage of lower withholding tax on interest " added Tushar Sachade.

Earlier, FPIs investing in Indian AIFs faced multiple litigations over whether their gains were capital gains or business income. In 2014, the government had clarified that FPIs are investors, not businesses, and their gains will be taxed as capital gains. However, for Category I and Category II AIFs, there was always a risk that their income could be classified as business income.

Foreign investors preferred direct investment as FPIs as it guaranteed capital gains tax treatment, while investing through an AIF carried the uncertainty of their gains being treated as business income. This regulatory gap had led to fewer FPIs choosing to enter the Indian markets through the AIF route.